Chapter 10: Arguments for and against Protection

The Ideal World of First Best In an ideal or a “first-best” world, all private incentives are aligned with benefits and costs to society as a whole In the first-best world supply and demand curves represent both private and social costs and benefits to society and all market are perfectly competitive In a first-best world free trade is economically efficient © 2016 McGraw-Hill Education. All Rights Reserved. 2

Distortions and Their Effects © 2016 McGraw-Hill Education. All Rights Reserved. 3

The Realistic World of Second Best Private actions will not lead to the best possible outcomes for society Two major sources of distortions in an economy – Market failures (externalities, monopoly, monopsony) – Government policies can distort an otherwise economically efficient market Externality is a spillover effect associated with production or consumption that extends to a third party outside the market. Negative externality exists when an external effect generates costs to a third party. Positive externality exists when an external effect generates benefits to a third party. © 2016 McGraw-Hill Education. All Rights Reserved. 4

Government Policies toward Externalities Tax-or-subsidy approach Property-rights approach © 2016 McGraw-Hill Education. All Rights Reserved. 5

The Specificity Rule It is usually more efficient to use the government policy tool that acts as directly as possible on the source of the distortion separating private and social benefits or costs A barrier against imports can be better than doing nothing in a second-best world. Still, the specificity rule shows us that some other policy instrument is usually more efficient than a trade barrier in dealing with a domestic distortion © 2016 McGraw-Hill Education. All Rights Reserved. 6

Promoting Domestic Production or Employment Local production produces spillover benefits New worker skills and attitudes Firms can find ways to lower their costs over time Extra costs to workers if they are forced to switch to jobs in other industries Pride in producing product locally Essential to national defense Way to redistribute income to poor or disadvantaged members of society © 2016 McGraw-Hill Education. All Rights Reserved. 7

Two-Ways to Promote Import- Competing Production © 2016 McGraw-Hill Education. All Rights Reserved. 8

The Infant Industry Argument A temporary tariff is justified because it cuts down on imports while the infant domestic industry learns how to produce at low enough costs Eventually the domestic industry will be able to compete without the help of a tariff © 2016 McGraw-Hill Education. All Rights Reserved. 9

The Infant Industry Argument © 2016 McGraw-Hill Education. All Rights Reserved. 10

How Valid is It? There can be a case for some sort of government encouragement, though normally private financing would fund promising business opportunities A tariff may or may not be good Some form of government help other than a tariff is a better infant industry policy than a tariff It is hard for a government to know which industries to support because it is difficult to predict which industries can reduce their costs enough in the future to create national benefits © 2016 McGraw-Hill Education. All Rights Reserved. 11

Cost per Job Maintained, 1990 © 2016 McGraw-Hill Education. All Rights Reserved. 12

The Dying Industry Argument and Adjustment Assistance Should government intervene to save a dying industry? - If we are in a “first-best” world, the answer is no. Since the social value of anything is already included in private incentives, ordinary demand and supply curves already lead us to the socially optimal choice. Trade adjustment assistance to workers and firms in import-threatened industries is a better policy, using the specificity rule, than, for example, a tariff, because adjustment assistance focuses on income losses, training, and worker mobility. © 2016 McGraw-Hill Education. All Rights Reserved. 13

The Developing Government (Public Revenue) Argument According to this argument, in poor developing countries the import tariff becomes an important source of not just protection but also government revenue The government revenue can be spent on otherwise underprovided public investments like education, health, and infrastructure © 2016 McGraw-Hill Education. All Rights Reserved. 14

Other Arguments for Protection: Noneconomic Objectives National pride argument National defense argument Income distribution argument © 2016 McGraw-Hill Education. All Rights Reserved. 15

Basic Elements: The Politics of Protection 1.The size of the gains for winners from protection, and how many individuals are in the group of winners. B p = total gains by producers N p = the number of individuals benefiting from the protection 2.The size of the losses for the losers from protection, and how many individuals are in the group of losers. B c = total gain by defeating the tariff N c = the number of individuals losing from protection (gaining from defeating protection.) © 2016 McGraw-Hill Education. All Rights Reserved. 16

Basic Elements: The Politics of Protection 3.Individuals’ reasons for taking positions for or against protection. a. The size of B p and B c b. Sympathy for various groups c. Ideology 4.Type of political activities and their costs (the costs of participation: time and money) 5.Political institutions and political process. © 2016 McGraw-Hill Education. All Rights Reserved. 17

When are Tariffs Unlikely? 1.Direct democracy: a.direct vote by individuals on tariffs b.voting is costless so that almost everybody votes. c.each person’s voting is based on her direct interest as winner or loser from protection. d.Almost always N c > N p But countries usually do not use direct votes to set protection. Rather, a group of selected representatives make the decision. Winning the political fight is gaining the support of a majority of these representatives or officials. Are some forms of government, like representative democracy, inherently protectionist? © 2016 McGraw-Hill Education. All Rights Reserved. 18

When are Tariffs Unlikely? 2.Representative democracy can lead to little or no protection. Each group is willing to devote all of its total gains (B p and B c ) to political activity like lobbying or contributions Politicians decide which side to support according to the amount of lobbying or contributions they receive Those opposed to the tariff (consumers) would be willing to spend up to B c to prevent the tariff, while the protectionists would not rationally spend more than B p The inefficiency of the tariff, which ensures that B c > B p, defeats the tariff © 2016 McGraw-Hill Education. All Rights Reserved. 19

When are Tariffs Likely? The group with smaller number of individuals can be more effective in organizing their political activities. If the benefits of participation are less than the costs to the individual, he/she is not likely to participate in the activity. The average gain per supporter of protection (B p /N p ) > average gain per opponent of protection (B c /N c ) The individual gains tend to be larger as the number of individuals in the group is smaller! The better organized protectionist lobby sways a majority of representatives © 2016 McGraw-Hill Education. All Rights Reserved. 20

Applications to Other Trade-Policy Patterns Tariff escalation pattern Economists have found that nominal and effective tariff rates rise with the stage of production, i.e. tariff rates are typically higher on final consumer goods than on intermediate goods and raw materials sold to producing firms. Why? The importance of group size and concentration for effective lobbying in favor or against a policy. Household consumers are usually less organized than producers in lobbying activities. © 2016 McGraw-Hill Education. All Rights Reserved. 21

Applications to Other Trade-Policy Patterns The bias in favor of producer interests over consumer interests also show up in international negotiations to liberalize trade. A concession by a country is a reduction the nation’s import barriers, allowing more imports. Each country is pressured to allow as much import expansion as it gets export expansion. The trade negotiators view their own import tariff cuts as a sacrifice because they have to answer politically to import- competing producer groups but not to masses of poorly organized import consumers. © 2016 McGraw-Hill Education. All Rights Reserved. 22

Applications to Other Trade-Policy Patterns The sudden – damage effect : Sympathy often increases when a group suffers a big income loss at once. The sympathy can arise from two sources: Compassion for those suffering large income losses. When a deep recession hits the whole economy. More people will identify with the less fortunate, thinking that “that could be me.” © 2016 McGraw-Hill Education. All Rights Reserved. 23

Can an Import Barrier Be Better than Doing Nothing, and Is It the Best Policy? © 2016 McGraw-Hill Education. All Rights Reserved. 24